Covered warrant

Covered warrant

In finance a covered warrant (sometimes called naked warrant) is a type of warrant that has been issued without an accompanying bond or equity. Like a normal warrant it allows the holder to buy or sell a specific amount of equities, currency or other financial instruments from the issuer at a specified price at a predetermined date.

Unlike normal warrants they are usually issued by financial institutions instead of share issuing companies and are listed as full tradeable securities on a number of stock exchanges. They can also have a wide variety of underlying instruments, not just equities and may allow the holder to both buy or sell the underlying asset. These attributes make it possible to use covered warrants as a tool to speculate on financial markets.

Contents

Structure and features

A covered warrant gives the holder the right, but not the obligation, to buy ('call' warrant) or to sell ('put' warrant) an underlying asset at a specified price (the 'strike' price or 'exercise' price) by a predetermined date. The price paid for this right is the 'premium' and with covered warrants you cannot lose more than this initial premium paid. They are limited liability instruments so there are no further payments or margin calls required to maintain a covered warrant position. Covered warrants offer a flexible alternative to private investors who seek to gain the leverage benefits of derivatives, but who wish to limit their risk.

When the issuer sells a warrant to an investor, they typically 'cover' (hedge) their exposure by buying the underlying instrument in the market. Covered warrants have an average life of six to 12 months, although some have maturities of several years.

In contrast to 'traditional' equity warrants, with covered warrants no new issuance of common stock occurs if the warrant is exercised. The underlying shares of common stock are usually either owned by the issuer of the covered warrants or the issuer has a mechanism, such as owning equity warrants for the underlying shares, through which they can obtain the shares. Covered warrants have proved highly popular due to their:

  • low cost
  • flexibility
  • limited liability
  • multi-strategy options

Comparison with options

Covered warrants are very similar to options, much more so than 'traditional' warrants. This is because covered warrants, just like options, can be created to allow holders to benefit from either rising prices or falling prices, by having both put and call warrants. They can also be created on a wide variety of underlying instruments not just equities and there are fairly standardised and are mostly traded on exchanges. The main difference is that warrants tend to have longer maturity dates typically measured in years instead of months as with options, and are easier to access for individuals as they can be bought and sold in the same way as shares in the stock exchange.

Trading warrants

Warrants are listed on a number of major exchanges, including the London Stock Exchange, Singapore Exchange and Hong Kong Stock Exchange and have proved popular with individual investors and traders particularly in Hong Kong, China [1] and Europe (especially Italy)[citation needed] . They are seen as a flexible tool offering leveraged exposure to a wide range of underlyings such as equities, baskets, indices, currencies and commodities, while offering the benefits of transparency and liquidity.

For example, popular indices include the FTSE100 in the UK or DAX in Germany, and popular commodities include oil, gold and wheat.

Risks

The main exposure is to Market risk as the warrant will be profitable only when the market price exceeds the strike price for a 'call warrant' or is below the strike for a 'put warrant'. The inherent leveraging effect of the warrant significantly increases the risks and traders that are using warrant to speculate can make or lose significant sums very quickly. With covered warrants the maximum loss is limited to the price paid for the warrant (ask or offer price) plus any commission or other transaction charges.[2] Thus, although warrants are classed as high risk they are not as risky as other investment products such as contracts for differences or spread betting in which an investor would have to pay for future losses.

Another aspect of risk is that an investor could lose their entire investment if the corporation issuing the warrant becomes insolvent.

See also

References

  1. ^ Warrants win over the China bulls
  2. ^ RBS Guide to Covered Warrants

External links

v · d · eDerivatives market
Options
Terms

Credit spread · Debit spread · Exercise · Expiration · Moneyness · Open interest · Pin risk · Risk-free rate · Strike price · The Greeks · Volatility
Vanilla options

Collar · Fence · Iron butterfly · Iron condor · Straddle · Strangle · Covered call · Protective put · Risk reversal

Binomial · Black · Black–Scholes · Finite difference · Garman-Kohlhagen · Put–call parity · Simulation · Trinomial · Vanna Volga method
Swaps
Forwards and Futures
Other derivatives

Credit default option · CLN · Contract for difference · CPPI · Credit derivative · ELN · Equity derivative · Foreign exchange derivative · Fund derivative · Inflation derivatives · Interest rate derivative · PRDC · Real estate derivatives · Real options
Market issues

Tax policy · Consumer debt · Corporate debt · Government debt · Late 2000s recession

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Look at other dictionaries:

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